This guest post was submitted by David Moss, professor at Harvard Business School, author of When All Else Fails: Government As The Ultimate Risk Manager, and founder of the Tobin Project.
As currently drafted, the Financial Stability Improvement Act of 2009 (released by the House Financial Services Committee on 10/27/09) contains several important elements for reducing systemic risk. It aims (1) to identify systemically dangerous financial firms, (2) to apply heightened regulation to these firms, (3) to establish a stabilization system to prevent or quell panic during periods of systemic distress, and (4) to create a resolution mechanism that would wind down complex financial firms when necessary. These could represent very important steps forward.
Unfortunately, these reforms may ultimately be undermined by one very significant weakness – the explicit requirement in the bill that the identification of systemically dangerous financial firms by federal regulators remain entirely secret, and never be revealed to the public. This is the bill’s Achilles heel.
The decision that there be “no public list of identified companies,” as the bill currently reads, stems from a belief that secrecy about the identity of these firms will limit moral hazard. However, after more than a year of costly bailouts, the federal government’s implicit guarantee of major financial firms is, sadly, rock solid. To try to make it magically disappear by refusing to name the most systemically dangerous firms not only won’t work, but will severely jeopardize the effectiveness of the regulation itself.
To maintain the pretense of secrecy, the bill includes some very unfortunate compromises:
● First, the bill does not require the systemic regulator to adopt a consistent (or universal) set of tough standards for all systemically dangerous firms, presumably to avoid compromising the secrecy surrounding these “identified” financial institutions.
● Second, the desire to hide these firms’ regulatory status (as systemically dangerous) means that they cannot be assessed fees in advance to cover their share of a resolution or stabilization fund; instead, the bill envisions ex post assessments on a much larger pool of firms, including a great many that are not systemically dangerous. (This would be like charging renters to cover the fire losses of homeowners.)
● Third, the attempt to ensure secrecy requires that all of the regulators’ reports to Congress themselves remain strictly confidential, thus weakening – and perhaps crippling – the essential process of democratic oversight.
Perhaps most disconcerting, all of these compromises will most likely be for naught, since the desired secrecy seems almost impossible to achieve. Virtually everyone already knows the identities of the most systemically dangerous firms; and, beyond that, leaks are inevitable.
Moreover, to the extent that secrecy was somehow maintained, it would leave the systemic regulator highly vulnerable to capture by the very financial institutions it was charged with regulating. Just imagine how weak regulations would become if the regulated firms themselves were the only parties that could weigh in on a proposed regulation, since the regulatory process was required to be hidden from everyone else.
The proposed legislation has many strengths. But without greater transparency, it will inevitably fall short – both in eliminating “too big to fail” financial firms and, most importantly, in preventing the next financial crisis. To be successful, the final legislation must require the creation of a public list of all systemically dangerous financial institutions; and it must ensure that these firms are subjected to dramatically heightened regulation to control excessive risk taking. In fact, the regulation of these firms must be so tough that they feel a strong incentive to slim down or break up in order to get off the list. Such a vital public mission will never be achieved in the shadows. (For more on this, see my recent piece on financial regulation in Harvard Magazine.)
By David Moss